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When you buy a new song, a particular type of sandal, or the latest personal gadget, your purchase triggers ripples through your social network as others rush to make similar purchases. This is particularly true for products bought on impulse.
But what about a product that represents a major investment? Can social influences from people you do not even know affect something as serious as, say, buying a new car? These were the questions that Blakeley McShane, an assistant professor of marketing at the Kellogg School of Management, and his colleagues Eric T. Bradlow and Jonah Berger at the Wharton School of the University of Pennsylvania sought to answer in a recent paper that examines the relationship between the number of new cars on the road in a given area and subsequent car purchases.
The first source of social influence one might consider is word-of-mouth: friends telling friends about their new car. But car purchases are relatively rare. One may, however, see hundreds of new cars a month: convertibles, pickups, sedans, and SUVS passing before one’s eyes in a stream of gleaming metal.
Measuring Visual Influence
To determine whether this visual influence could be prompting people to buy cars, McShane and his colleagues started with a database of 1.6 million car sales and leases made over the course of nine years in 1,000 zip codes across the country. Running a few numbers showed that in areas where more cars had been bought in the past month, more cars were also being bought a month later. In order to determine whether this trend had to do with visual influence—and not, say, with how much money people made in those zip codes or the presence of a sale—they dug deeper.
The authors reasoned that if visual influence were at play, only the cars seen in the immediate vicinity on a regular basis would influence car sales in a county. They examined whether, for a given zip code, vehicle purchases in closer zip codes influence future purchases more than those in distant zip codes. They organized the zip codes into groups: each zip code was grouped with an adjacent zip code, a zip code 10–30 miles away, one 30–60 miles away, and one more than 100 miles away. (Key demographic information, like income, was kept the same across all zip codes grouped together to control for non-visual effects on car buying.)
Analyzing how much each zip code’s purchases affected its partners, they found that, indeed, the effect of past purchases on future purchases decayed with increasing distance between zip codes. Within the focal zip code, the effect of past purchases on later purchases was large; the effect of cars bought in the adjacent zip code on those bought in the focal zip code was moderate; from the zip code10–30 miles away, the effect was even smaller; and with the zip codes even farther away—whose inhabitants would almost never be seen in the focal zip code—the effect was not noticeable. This pattern is “at least consistent with visual influence,” McShane says.
To make a stronger case, the team looked for other variables that would be consistent with visual influence. For instance, when they saw the amount of variability in the strength of the effect, they checked to see what differed among zip codes. “What could possibly explain the fact that [the effect in] Westchester, NY, is bigger than Washoe, Nevada, which in turn is bigger than Wake, North Carolina?” McShane asks. “It turns out that, among other things, we find that in places where people commute more by car, there's a greater effect.”
This makes sense, because more commuters on the road every day means more exposure to cars. And, indeed, according to weather data the team obtained, areas with more sun showed a stronger effect as well. There were no relationships between population size or number of vehicles per household and effect size.
The team also found that there were differential impacts in the effects of car purchases by gender. Building on prior work demonstrating that people from one social group are more likely to avoid products associated with other social groups in product categories relevant to identity, the team hypothesized—and found—that, for example, prior sales to men had a greater visual influence effect than prior sales to women among car categories more strongly associated with men than women (e.g., pickup trucks). “It doesn't show that's it visual. But it shows that it's consistent with the literature on identity, making it much more likely social influence is at play.”
According to the team's analyses, for every seven cars that at are sold, another one is sold as a result of local inhabitants seeing the others on the road. That is, there is a spillover effect where direct purchases generate further purchases due to visual influence. These additional purchases, McShane suggests, need to be taken into account when assessing the impact of an advertising campaign: a dealer may be getting more bang for his buck than he thinks.
A good or service often costs us more than what comes out of our pocketbook. The $9.99 that a large chain store charges for a tee-shirt may cover the cost of producing, transporting and selling that tee-shirt, but not the societal costs of poorly compensated labor, emissions of pollutants and greenhouse gases, or the hollowing out of local businesses.
Many customers care about these societal costs, and so companies have an incentive to invest in, for instance, organic cotton. Doing so can substantially improve a less-established company’s reputation. But for companies that already possess rock-solid reputations, these activities do not provide the same level of benefit. As Daniel Diermeier, a professor of managerial economics and decision sciences at the Kellogg School of Management, puts it, “The payoff for investing more, and being more socially responsible, likely diminishes over time.”
Yet, established companies do continue to invest in their image. Consider Wal-Mart, which continues to spend a considerable amount of time and expense engaging in reputation-enhancing activities, such as taking steps to provide affordable health care for employees, or pledging to decrease stores’ greenhouse emissions.
Is it the case that companies like Wal-Mart are genuinely altruistic? Perhaps. But altruism need not be the only explanation, according to a new study by Diermeier and his colleagues Jose Miguel Abito, a doctoral student in economics at Northwestern University, and David Besanko, a professor of management and strategy also at the Kellogg School. Their study suggests that seemingly counterproductive levels of socially responsible activity are in fact predicted by companies acting rationally—at least once social activism is taken into account.
Company vs. Activist
The researchers set out to simulate interactions between a company and an activist hoping to undermine that company. The activist’s campaign against the company is represented as a game that unfolds across time, with each party acting in its own best interest. The company’s goal is to gradually enhance its reputation while expending as little effort as possible. The goal of the activist, on the other hand, is to encourage effort by preventing the company’s reputation from getting too good, which would in turn allow the company to coast on that sterling reputation instead of engaging in even more socially responsible activities.
The activist has two tools at its disposal: criticism and confrontation. Criticism—which represents activities such as letter-writing campaigns or shareholder resolutions—calls attention to a company’s shortcomings and, when effective, steadily chips at the company’s reputation. However, confrontation—which describes activities geared toward creating a well-publicized spectacle, or crisis—has the potential to deliver a sudden, stinging blow to the firm’s reputation. (Consider, for a real world correlate, the rash of bad publicity Apple faced over working conditions at Chinese factories operated by its contract manufacturer Foxconn.)
As the activist goes about its business, the company must decide how little socially responsible activity it can get away with doing while still building, or at least defending, its reputation. The company cannot ward off a crisis per se—if a company sells burgers, after all, it is unlikely to ever completely appease vegetarians—but it can build enough goodwill to cushion the impact of a crisis.
Researchers varied factors such as the activist’s level of patience (that is, the amount of time and thus resources it can devote to the campaign), the effectiveness of the activist’s attacks, and the extent to which a firm values its reputation.
They found that, over the short term, the presence of an activist actually tends to reduce the amount of reputation-building work a firm is willing to engage in. If a firm does good deeds and is still attacked, says Diermeier, then the firm may become discouraged and cut back its socially responsible activities. But over the long term, as the researchers suspected, the activist does prod the company to engage in more reputation-enhancing activity than it would in the absence of the activist. This suggests that activism serves a real social purpose: by providing downward pressure on the company’s reputation, an activist keeps a company motivated to do more good deeds than it would otherwise do. Even companies with seemingly strong reputations have an incentive to build a buffer.
Tempting Targets and Dangerous Activists
In addition to providing an explanation for why companies like Wal-Mart continue to devote resources to building their image, the study provides an intriguing answer to another longstanding question. “Large Western oil companies often complain that they’re being targeted by activists, while the activists do not go after Chinese oil or nationally owned oil companies with far worse environmental records,” Diermeier remarks. “So they always say, ‘Why are you going after us? You’re not going after the guys over there.’ And the answer our model provides is, well, that is true because Chinese local competitors do not have brand equity; that’s not the way their business is structured. Their reputation is much less valuable to them than it is to the large, well-integrated, globally operating multinational companies.” In other words, an activist can most effectively influence a company that holds its reputation in very high esteem, so why would an activist with limited resources bother with a company that does not?
The researchers’ study also tells us something about which activists tend to fare best and thus pose the most danger to firms. A patient activist—and Diermeier points to Greenpeace as a good example—is at an advantage because it has the time and the means to successfully induce a crisis. But interestingly, criticism alone is not always the most effective approach. All else being equal, activists who engage in a combination of criticism and confrontation generally do best of all. If an activist relies solely on criticism, it does not push a company’s reputation down enough. “But if you’re only creating a crisis, then at some point the company gives up,” Diermeier explains. The risk for the activist is that the company may simply stop trying to please you. For similar reasons, the most effective activist is passionate, but not too radical. Says Diermeier, “There’s kind of a sweet spot in the middle.”
Many people think about risk management as a defensive strategy, a tool for minimizing exposure to economic crises or public-relations blowouts. But Russell Walker, a clinical associate professor of managerial economics and decision sciences at the Kellogg School of Management, argues that businesses should be thinking about risk management very differently. He has just written a book on the topic, Winning with Risk Management, published by World Scientific Press, which he kindly agreed to discuss with Kellogg Insight. Here is our conversation, lightly edited and condensed. (For a longer version of our conversation, listen to the accompanying podcast.)
Kellogg Insight: Your book argues that a company’s risk management strategy can actually bring it a competitive advantage. Can you start by explaining just what you mean?
Russell Walker: The world of business has taught us that companies develop competencies and use those to create advantages. Companies might, for instance, be excellent in operations, in marketing, pricing, branding, etc. So in the same way we would ask ourselves, “how do we compare against another firm on pricing?” or “how do we compare against a firm on branding?,” we could ask questions about risk management. How does the organization tie into knowledge networks, how is the organization exposed to global stresses, global shocks, shocks in supply chains, or even risk from regulation?
KI: You point out that operational risk in particular is often mismanaged—to a company’s peril. What do you mean by operational risk, and why is it important to manage it well?
Russell Walker: Operational risks are the negative outcomes associated with executing a strategy. It’s often the case that we remember the very catastrophic, image-driven, external events: explosions, hazards, tornados, what have you. But many organizations fail not because of outside stresses, but because of challenges internally. There may be technological challenges. And there may be organizational issues dealing with information that might suggest that risks are different. Operational risk mostly is the implicit risk that an organization has accepted by setting a strategy.
KI: So let’s move to a couple concrete examples. Your book takes us through the way two different cell phone companies, Nokia and Ericsson, both responded to the same crisis, a fire in a supplier’s factory that delayed production of a critical component. But the two companies’ responses to this crisis were night and day. What happened?
Russell Walker: Great question. The case is a famous one because it highlights how two companies were exposed to essentially the same risk. Both companies were using a single supplier—Philips in this case—which made a memory chip that was unique in the cell phone industry. Both Nokia and Ericsson found themselves dependent on this single supplier. When Philips was unable to produce chips because of a fire event at its factory, Nokia and Ericsson took drastically different approaches.
Ericsson was laissez-faire: “we’ll wait for more information on our supplier.” Nokia more proactively sought out information. And as you might guess, that more proactive approach by Nokia allowed them to secure the international supply of this memory chip, preventing Ericsson from acquiring any supply. Nokia was able to provide its competitor Ericsson a deathblow, and in doing so gained market share. They picked up 3% of the world’s market share and paid Ericsson nothing for that. The case has changed how technology companies in particular view their global supply chain and assess the risk of their suppliers.
KI: How so?
Russell Walker: We have found that many of the components used in technological devices like iPhones or iPads now accept one of many different components in the marketplace. Whereas in the case of Nokia and Ericsson, the phones were designed around one particular memory chip—only one, made by one supplier—now many of the devices have built in an engineering flexibility that allows them to receive one of many different components. We’ve also seen that Apple has changed its relationship with suppliers. It has a nearly exclusive relationship with Foxconn and develops very deep relationships with its partners. This case shows that both Ericsson and Nokia lacked that kind of deep relationship with a supplier.
KI: Would you say that there are any other ways that technology has shaped the risk landscape?
Russell Walker: Many ways. T.J. Maxx is a large retailer here in the U.S., and they’re not a company that you would expect to necessarily be competitive in the world of data security. But because they elected not to take particular actions to upgrade the security on their credit card transaction systems, they became the victim of a very sophisticated and targeted fraud scheme in which individuals stole credit card information from the satellite transfers from T.J. Maxx stores to their headquarters.
T.J. Maxx is a retailer. They compete on selling brands and clothes and all the things that we wish to wear, not on credit card security and in the technology necessary for that. But now even companies that run small e-commerce webpages are exposed. The case highlights—and it was the largest example of credit card fraud to date in the U.S.—the need for companies to stay abreast of technological risk.
KI: Time and again your book frames risk as this opportunity. I know you’ve touched on it briefly before. But why do you think that the more positive aspects of risk are ignored?
Russell Walker: They’re largely ignored because risk has been presented as a downside, not necessarily as an upside. What is fascinating about risk and understanding your competitive position against risk is that if your competitor is to falter—if you could assist your competitor in some demise—their assets (be they market share, factories, brands, etc.) get transferred. And in the context of risk, if we look at the examples of Nokia and Ericsson, and even Toyota and British Patroleum, we see that assets get transferred for nothing. What’s really exciting about competing on risk is that you could “buy” your competitor’s assets for free. That largely will define the winners and the losers in a marketplace.
KI: You said something really interesting in your book about CEO tenure, and how that might actually influence how companies think about risk. Do you mind sharing?
Russell Walker: Exact numbers are in the book, but I believe a typical CEO tenure is 4–7 years. But it’s not uncommon for it to even be less. This suggests that a CEO, given his or her reward package, may take risks or make investments that maximize short-term results, and potentially expose the firm to larger risks later down the road. We could look at family businesses as a comparison, where a family business has the goal of preserving the company over a very long period of time, in fact even transferring it to the next generation. And we find that they take different risks, risks more in the direction of, “how do I preserve this and grow this in a sustainable way?” versus “how do I grow revenue rapidly, quickly?”
KI: So it might not be a bad thing for us all to start thinking about public corporations more as family corporations.
Russell Walker: Well, in the sense that you own it and it’s yours, you think about it very differently. In fact it has been suggested that CEOs should be compensated entirely by stock, entirely by ownership.
No one wants to make a mistake—particularly not one that will be painfully evident to his or her boss the next day, week, or quarterly review. But while making a mistake is bad, people tend to avoid the mere appearance of making a mistake just as vigilantly.
Employees are often focused on what are known as career concerns. Since promotions, raises, or other benefits frequently depend not just on a person's performance but on what her boss thinks about her abilities based on that performance, employees consider their professional reputation when making decisions. The familiar "cover your posterior" strategy kicks in: people stick with the safe option rather than taking a smart risk that could go poorly and make them seem less competent.
Career Concerns for Entire Companies?
Meghan Busse, an associate professor of management and strategy at the Kellogg School of Management, wanted to find out if career concerns might play out on a larger scale. Can the desire to cover one's backside alter the actions of entire companies the way it changes the behavior of individual employees?
Busse and her colleagues, Severin Borenstein at the University of California Berkeley and Ryan Kellogg at the University of Michigan, looked at firms in the natural gas industry. ComEd, PG&E, and other local utilities companies buy gas and deliver it to consumers; regulatory bodies called public utilities commissions oversee the companies, ensuring that they buy enough gas to keep consumers stocked, and at a reasonable price. If a commission thinks a local utility company is behaving imprudently—paying too much for gas, for instance—it can call the utility before a regulatory review, much as a boss might call an underperforming employee in for a performance review.
During a review, Busse explains, regulators "are essentially going to Monday morning quarterback and decide if the distributor made the right choice in any particular circumstance. That's going be painful and unpleasant because in 20/20 hindsight, everything looks clearer.” The possibility of a review might foster career concerns, thought Busse, encouraging companies to focus less on making the smartest decisions—even if they come with risks—and more on avoiding actions that might look like mistakes.
Avoiding the Appearance of Imprudence
So Busse and her colleagues investigated how utilities buy and sell gas. Local utilities buy much of their gas through long-term contracts. To handle short-term changes in demand, the firms can either buy more gas or sell their surplus on two timescales: during the last week of each month, in what is called the “forward market,” or the day before they need it, in what is called the “spot market.”
If career concerns are guiding utilities' strategies, Busse hypothesized, the situation they would most want to avoid would be selling their extra gas in the forward market, only to face a spike in demand and have to buy it back—at a much higher price—in the spot market. This would be especially true in tight markets, when demand, and prices, are high. Even if profiting from a surplus seems like a good idea at the time, selling it off only to buy it back for more counts as imprudent behavior that can trigger a review. It would be easy for regulators to home in on the utility's misstep during that review, Busse explains. "They can point the finger and say: You made a mistake. You made the wrong judgment about how much gas you were going to need.”
But if utilities refrain from selling gas on the forward market and still have to buy more on the higher-priced spot market, this does not necessarily look like a mistake. Sometimes there are limits to what can be purchased on the forward market, so perhaps the utility had simply been unable to buy as much as it needed. "That's a plausible story because that's sometimes true," Busse says. "The regulator can't say you messed up, because you haven't taken an action they can point to and know for sure is a mistake."
Busse and her colleagues analyzed spot and forward market prices and trading volume data from more than 100 local natural gas markets across the U.S. from February 1993 to March 2008. With these data, they could not look directly at whether individual companies were acting as expected. They could, however, look for larger trends that would result from many utilities behaving this way: when demand is high, there should be fewer trades and higher prices during the forward market than would be expected based on the performance of the spot market, evidence that utilities were hesitant to sell their gas and risk a mistake.
After conducting regression-based analyses of the data, the researchers indeed found this evidence. When the markets were tight, they saw a forward price premium such that a $1 rise in the expected spot price would cause a $1.25 to $1.27 rise in the expected forward price. A higher spot price was also linked to a decrease in trading volume: that same $1 increase in expected spot price leads to an 8.9% decrease in trading volume in the forward market. Other potential explanations for the trends—such as companies paying a premium to lock in a supply of gas or to avoid the risk of paying a still higher price on the spot market—cannot explain the entire pattern of results.
These trends in company behavior could make whole markets less efficient. "You have inefficient outcomes when you have somebody who really needs gas, and is willing to pay a high price, [but] can't get someone to sell them the gas at that price," Busse says. If a local distributor in one region likely has more than enough gas to see them through the month, they would, in most markets, sell the extra gas to a distributor in a region where it is getting colder and demand for gas is high. But if the market is tight, the first distributor might not sell—just in case its own area gets cold and it has to buy back gas at a high price. "They're not willing to sell because they don't want to take on the risk that they're going to end up needing it and then be in this really unpleasant prudency review," she says.
This result built on the earlier research that showed individual career concerns—employees doing what is best for their own professional reputations—could lead to inefficient choices within a company. But as far as the researchers know, this is the first paper that demonstrates how career concerns can actually produce inefficient markets.
The same thing likely happens in other sectors as well, Busse suspects. "There's a new input supplier, but purchasing managers don't buy from them because they don't want to be the ones who tried out something new and derailed the production process," Busse says. "Maybe this is actually a better input, but nobody will try it. And therefore what would be a market innovation doesn't happen because nobody's willing to take the risk and go first."
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